living dangerously in this year too

• This was supposed to be a stress-free year for the global economy. By January the financial crisis had faded and Europe’s sovereign-debt crisis seemed less acute. America’s economy was resurgent. Investors piled into equities and sold some of the government bonds they’d bought for troubled times. If there was a worry, it was that emerging economies would grow too quickly, inflating commodity prices.
• The year without crisis is not to be. First, Arabian upheaval put oil markets on edge. Then earthquake, tsunami and a nuclear accident clobbered the world’s third-largest economy. How much of a setback to growth do these twin crises represent? And how should economic policymakers react to them?
• Japan’s share of world output has been shrinking for decades, but at 9% it remains large enough for the hit to the country’s growth to subtract noticeably from global output. Then there are the ripple effects on the rest of the world. Japan is a large—in some cases the sole—supplier of intermediate goods to the world’s electronics and automotive industries, from the hardened glass on Apple’s iPad to gearboxes in Volkswagens. Many makers of such parts have had to slow or halt shipments because of damaged roads, power cuts or the loss of components from their own suppliers. The effects have spread well beyond Japan, causing shutdowns from South Korea to Spain. Still, the history of such disasters is that much of that lost production is eventually recovered and reconstruction delivers a fillip to subsequent growth.
• Pinpointing the impact of Arab political turmoil is complicated by the fact that oil prices were already rising thanks to a brighter global economic outlook. Nonetheless, a good portion of this year’s 25% increase seems due to worries over supplies. A rule of thumb holds that a 10% increase in the price of oil trims 0.2 percentage points from global growth. At the start of the year, the world looked likely to grow by 4-4.5%. A crude estimate is that the two crises will subtract between a quarter and half a percentage point from that.
• That may not capture the full effect. Crises by their nature generate clouds of uncertainty . Businesses postpone capital spending and hiring until the clouds clear. Investors seek the safety of bonds and lose their taste for equities.
• Economic policymakers can’t make peace between Arab rulers and their people or stabilise Japan’s nuclear reactors, but they can minimise the collateral damage. The greatest burden is on the Bank of Japan. Its efforts to cure deflation over the past 15 years have too often been timid. That could not be said of its rapid response to the tsunami. It poured cash into the banking system in a pre-emptive strike against panic hoarding. And it expanded its purchases of government and corporate debt and equities. Still more “quantitative easing” can keep bond yields from rising as the government borrows for reconstruction, and help the fight against deflation.
• What should the rest of the world do? In a show of sympathy the G7 joined the Bank of Japan in selling the yen after it spiked dramatically. Such actions should be limited, however. Japan is too dependent on exports and its priority should be stimulating domestic demand and ending deflation, not cheapening the yen. A better way for outsiders to help is to ensure that concerns over radiation in Japanese products do not become an excuse for protectionism.
• Other central banks face a more complicated task. Even as higher oil prices and hobbled Japanese production reduce growth they add to mounting inflation risks (Britain is now fretting over inflation of 4.4%). But most rich-world economies have ample economic slack, and in several countries fiscal tightening will tug at recovery. Britain’s coalition government has reaffirmed its commitment to austerity with this week’s budget , and America has begun to cut spending. Both the Bank of England and the Federal Reserve should resist the temptation to tighten soon.
• The European Central Bank seems intent on raising interest rates next month. That would be a mistake. In the euro zone underlying inflation and wage growth are both subdued and inflation expectations are under control. By raising rates the ECB would strengthen the euro and frustrate the efforts of countries like Greece, Ireland and—the next in line for bailing out—Portugal to grow their way out of their debts.
• There is only so much economic policymakers can do about crises that spring from war or nature. In this case, the priority should be not making matters worse.

Financial crises and property busts go together

• Property’s grip on people is unrelenting. After the worst housing crash in memory, almost two-thirds of Americans still think that property is a safe investment. In Britain ministers hold summits to work out how to get first-time buyers into a market where prices are falling. In China anxious buyers queue to snaffle yet-to-be-built apartments. The world of commercial property is saner, but not by much. A bounceback in office values in London has prompted fears of a new bubble. Cranes dot the Chinese skyline, where more than 40% of the skyscrapers to be built over the next six years will be sited.
• Property is more than just a place to live and work. For many people, it is the biggest financial bet they will ever make. That bet has been disastrous for plenty of homeowners. Over a quarter of mortgage-holders in America owe more on their loans than their homes are worth. House prices there have fallen back to 2003 levels and are still declining—by 2.4% year-on-year in December. A huge pipeline of foreclosed homes is still on its way to market: distressed transactions account for 66% of sales in California. Prices will probably fall again this year, sapping confidence and preventing people from moving to find work. Programmes to modify mortgage payments have been disappointing: for some underwater borrowers it may make more sense for the state to help reduce the principal.
• At least prices in America are back to their long-run average compared with rents. For those with cash, homes are more affordable than they have been for years. In many parts of Europe, prices still have a long way to fall to revert to that sort of value and there is lots of downward pressure. Oversupply weighs on the market in places like Spain, where a construction boom turned to bust. Credit is constrained (a big worry for commercial property, too, given the amount of debt that needs to be refinanced). The threat of rising interest rates looms over the many borrowers with adjustable mortgages.
• In emerging markets policymakers have a different problem: holding prices down. A property bubble, many reckon, is the biggest threat to China’s economy. A succession of measures have been introduced to subdue speculative buying and force developers to increase the supply of homes. There are sound reasons for prices to rise in China, given income growth and huge pent-up demand for decent housing. But policymakers are having to fight to keep things under control.
• The irony is that property’s appeal is founded on its supposed solidity. It is no coincidence that the housing bubble started in the aftermath of the dotcom bust. Out went fantasy business plans; in came a real asset with a proven record. But , property has dangerous qualities.
• One is its size. American households have more of their wealth in real estate than any other asset; it is a similar story elsewhere. So when things go wrong, the consequences are more serious than if there is a slump in equities, say. Worse, property is a magnet for debt. Lenders have to set aside less capital for loans against property because of its security as collateral. Individuals have no other opportunity to take on so much leverage. As prices go up, a deadly feedback loop forms: rising collateral values enable banks to extend more credit, which means prices can be chased higher. Things can spiral very quickly: there was a doubling of mortgage debt in America between 2001 and 2007. It is leverage that explains why property busts have a habit of causing financial crises.
• Property is also an inefficient asset class. It is lumpy: you can offload parts of your share portfolio, but you cannot sell off the kitchen. It is illiquid, which can strand people in their homes even if they are not in negative equity. And it is inefficiently priced, not least because as an asset class it is hard to short: you can’t hedge your exposure.
• So governments should be neutral about home-ownership, whose benefits have been oversold. People will always want to buy houses: they do not need a shove from subsidies. In America plans to wind down Fannie Mae and Freddie Mac, which buy and guarantee mortgages on the government’s account, are welcome. Tax deductions on mortgage interest should go. So should distorting exemptions on capital-gains taxes; it is better to cut the transaction taxes that make it expensive for people to move.
• Politicians will be loth to cut the value of their electorate’s biggest asset, however. Which is why lots of people are now looking to central banks to intervene when property booms get going. That already happens a lot in Asia; Western central banks are also moving in this direction. The Swedes last year imposed a maximum loan-to-value ratio of 85% on mortgages, for instance. Good. Standing idly by is not much of a policy. And central banks have tools at their disposal, including interest rates, that can dampen things down.
• Regulators have failed to spot bubbles in the past, however. And booms can be hard to stop when they get going: just ask the Chinese authorities. Discretionary interventions should be on top of standing rules, not instead of them. There should be no room for the wildest mortgage products—those that do not seek verification of income, say. But the systemic issue is the amount of debt that borrowers take on. Property busts are at their most destructive when borrowers fall quickly into negative equity (one reason to worry less about China is the small amount of debt that homebuyers have). A cushion of equity—10-15% of the property’s value, say—should be required of new borrowers as a matter of course.
• This should be phased in gradually. Unlike getting rid of mortgage interest relief, which is relatively painless when interest rates are already low, a minimum equity provision would hurt the economic recovery (especially in America, where the government is guaranteeing loans with tiny down-payments). And there is also a risk of excluding creditworthy borrowers, particularly first-time buyers and the self-employed. But it cannot wait too long. Asking people to save up for longer is a reasonable price to pay for a safer system.

Brazil,absolutely the most attractive emerging market right now

• scene at the BM&FBOVESPA, Brazil’s main stockmarket, earlier this month encapsulated Brazil’s thriving alternative-investment industry. A champagne-sipping crowd milled around José Carlos Reis de Magalhães, the boss of Tarpon, a local private-equity firm, on the floor of Brazil’s slick, renovated exchange. They were toasting the successful initial public offering (IPO) of Arezzo, Brazil’s largest shoe retailer. Tarpon had bought a 25% stake in Arezzo for 76m reais ($43.8m) in 2007 and seen its investment nearly quintuple in value in three years. Tarpon’s own share price is up by 143% from a year ago. The firm counts big endowments, like Stanford University, among the investors in its $3.5 billion fund.
• Tarpon is not the only part of Brazil’s private-equity and hedge-fund industry to have attracted international attention. In September Blackstone, a private-equity giant, paid $200m to take a 40% stake in Pátria Investimentos, a local private-equity firm. In October JPMorgan Chase’s Highbridge hedge fund, the world’s largest, bought a majority stake in Gávea Investimentos, a $6 billion Brazilian fund. Brazil is “absolutely the most attractive emerging market right now,” says the boss of a big American private-equity firm. Other economies may be bigger but investments there are seen as politically riskier. The Brazilian government is less hostile in its attitudes toward private, and foreign, investment.
• Sceptics recall the last time people declared a golden age for private-equity investment in Brazil. Foreign firms and banks flocked there in the 1990s. When shocks from the Asian crisis pulsed through the country, and Brazil devalued the currency in 1999, plenty flocked out again. Some local firms survived the bloodshed: GP Investments, Brazil’s largest private-equity firm, is still going strong, as are a handful of others from that era. But most global firms left and didn’t come back until 2006, when investment activity started to rev up again.
• Brazil is returning to a bigger, more resilient economy. OECD countries saw their GDP decline by 2.7% over the course of 2008 and 2009; Brazilian GDP grew by 4.9% during that time, and by a further 7.5% last year. It is now the world’s eighth-largest economy and could overtake Britain, France and Italy to become the fifth-largest by the end of this decade. The commodities boom is one source of growth: Brazil is the largest exporter of sugar, coffee and meat, and second only to America in soyabeans. Consumer spending is vibrant. The country is the world’s second-largest market for cosmetics and the third-largest for mobile phones. Its hosting of the 2014 FIFA World Cup and 2016 Olympics will require at least $50 billion in infrastructure investments, many of them privately funded.
• Money is pouring in, as investors throng funds’ offices on bustling avenues like Faria Lima in São Paulo and Paiva de Ataulfo in Rio. Local hedge funds managed around $243 billion in assets at the end of 2010, up by 23% from 2009, according to the Brazilian Financial and Capital Markets Association, an industry group (see chart 1). Private-equity firms oversee $36 billion.
• There are several reasons for this explosive growth. One is the maturing of the country’s capital markets. Laws protecting minority shareholders’ rights, for example, have fostered confidence. Brazil’s exchange is now the fourth-largest in the world by market value. That is a boon for hedge funds, which need liquid instruments to trade, and for private-equity firms, which use IPOs to cash out their investments.
• Investors are freer to choose where to put their money, too. Brazil’s 400 or so pension funds, with assets of around $342 billion, have been allowed to place money more freely with alternative-investment firms since 2009. Pensions now account for around 22% of investments in private equity and venture capital, according to Claudio Furtado of Fundação Getulio Vargas, a university. Valia, the $6.8 billion pension fund of Vale, a miner, has increased its allocation to private equity from 1% of assets three years ago to 6% in 2011.
• The Brazilian government’s sunny view of hedge funds and private-equity firms also helps explain their growth over the past few years. In many countries governments treat private-equity firms and hedge funds with either loathing or teeth-grinding tolerance. Partly because bank loans are very short-term, the tone from Brazilian officials is different. “As a country and an economy, we need private equity and venture capitalists to invest and to help our entrepreneurs,” says Maria Helena Santana, who runs the CVM, Brazil’s equivalent of America’s Securities and Exchange Commission (SEC).

• When Brazil’s government raised the tax on foreign investment in fixed-income instruments last year from 2% to 6%, private-equity firms complained. The government promptly changed it back—but only for them. BNDES, Brazil’s development bank, has put $1.1 billion into private-equity funds, and is the industry’s top investor. Private equity accounted for a higher proportion of GDP in 2010 than in most other emerging markets (see chart 2).

• Another reason for the rise in alternatives is a decline in interest rates. The benchmark Selic rate stands at 11.25%, much lower than the 26.5% it was set at in 2003. The threat of rising inflation may have reversed that trend in the short term but rates are expected to keep falling in the long run. Brazilian investors can no longer reap extraordinary returns just from parking their money in risk-free bonds. Maurício Wanderley of Valia says he looks for returns of 25-30% on his private-equity investments, and so far they’ve been “above our expectations”. Brazilian hedge funds have posted annualised gains of 17% over the past three years, according to EurekaHedge, a research firm. (North American funds have managed 8.6% on an annualised basis in that time.)
• The buzz around Brazil will put those returns under pressure, however. Alvaro Gonçalves of Stratus, a Brazilian private-equity firm, appears dismayed at the speed with which “armies” of global investment firms are arriving. Rather than fly in for visits, they now want to set up offices and hire local deal-makers. The competition is causing salaries to rise. Jon Toscano of Trivèlla Investimentos, a private-equity firm, estimates that executive salaries have nearly tripled in as many years.
• Greater competition has less effect on the hedge-fund industry, since there are many trading opportunities. But for private-equity firms, where the number of deal opportunities is smaller, there are huge consequences. Prices for deals have already gone up in the past year—although most investors say that companies are still not as expensive as they are in China or India, where there is even more competition.
• The three largest private-equity deals in Brazil’s history took place in 2010, all of them carried out by foreign firms. Stakes in consumer-related companies are particularly prized. Carlyle Group, an American buy-out firm, did three deals in 2010, involving a lingerie company, a travel firm and a health-care company—all of them bets on Brazil’s middle class. Many local firms are ramping up their efforts to look for deals beyond São Paulo and Rio, where most of the foreign firms are based.
• Ballooning deal prices may also drive crafty local firms to invest more money abroad. 3G Capital bought Burger King, an American fast-food chain, for $4 billion last year because the management felt Brazil had become too expensive and that global firms were too busy chasing deals in emerging markets to notice the opportunities at home. “You can do a buy-out in the United States of a global brand, a well-known company, and really face no competition,” says Alexandre Behring of 3G.

• Back in Brazil, some worry that the new entrants’ preference for big leveraged buy-outs (LBOs) could damage the industry’s unusually wholesome reputation. In Brazil private-equity deals are mostly unleveraged, and often involve minority positions in medium-sized companies. That’s partly because high interest rates make debt crushingly expensive—the average rate for a commercial business loan is 29%. But even if credit becomes more readily available, Brazilian firms are nervous of it. Brazilian managers reel off the names of highly leveraged buy-outs that have tanked in the West. “I hope we can avoid the image that we are raiders and vultures,” says Mr Gonçalves. “This is the profile that these large LBO firms left in markets, and we don’t want them to do that here.”
• It is more likely that the foreigners will have to adapt to Brazil than the other way round. Unlike China and India but like many other emerging markets, Brazil has only a limited number of large firms to invest in. Private-equity investors won’t be able to swim in a sea of $500m and $1 billion deals. Given the scarcity of long-term financing, some are looking to lend instead. “A large part of our plan is to provide credit and growth-equity capital” in Brazil, says Glenn Dubin, the boss of Highbridge.
• Although Brazil’s equity markets are liquid, concentration remains a problem for hedge funds. Eight companies account for more than 50% of the market value of the BM&FBOVESPA. Shorting the shares of smaller firms is expensive because it is hard to find shares to borrow. Larger funds have to be patient when building up positions. Luis Stuhlberger of Credit Suisse Hedging-Griffo, Brazil’s largest hedge fund, says it is like being “an elephant in a bathroom. You have to move very slowly, otherwise you break everything.”
• Funds must also comply with strict requirements for transparency and liquidity. Brazilian hedge funds must report their net asset values daily and their positions on a monthly basis. These are then posted publicly on the website of the CVM for anyone to see. Thanks to the country’s long experience of volatility and inflation, most investors do not agree to long lockup periods for their money. As a result, many funds offer daily liquidity, which means they do not have much flexibility with their strategies and cannot take illiquid positions.
• Some managers complain that Brazil’s regulatory system costs them their edge, because others know what they are up to. But most don’t seem to mind too much. Transparency brings legitimacy to the industry and calms investors, many say. Frauds like Bernie Madoff’s, which have dented investor confidence in hedge funds in America and Europe, are less likely to go unnoticed in Brazil. “Madoff would never happen in Brazil,” says Eduardo Lopes of Ashmore, an emerging-markets fund.
• Indeed, other markets are moving closer to a Brazilian-style system of regulating alternative investments. Hedge funds and private-equity firms have been mostly unregulated in America and Europe, but that is set to change. Later this year, America will start to require funds to register with the SEC and disclose some of their holdings to regulators. In France hedge funds now have to report their short positions; it is possible that other countries in Europe will enact similar requirements. “The financial crisis showed that many of the choices we made before are good choices,” says Ms Santana of the CVM.
• There are still plenty of risks in emerging markets, of course. Inflation remains a worry, and Brazil’s battle to keep down the value of the real has led to other capital controls on top of the tax on foreign investment. The BOVESPA index has declined by 6% in the past month. But here too, Brazilian alternative-investment managers claim an edge because they have been through rocky markets many times before. “They’ve basically taken as much chemotherapy as you can take and survived it,” says a foreign fund manager.
• Many managers in China and other emerging markets are familiar only with good times, so some investors worry that they might not perform well if the economy stumbled. Arminio Fraga, a former central-bank governor who founded Gávea, thinks the volatile global economic environment will play to Brazilian managers’ strengths in the coming years: “There are a lot of things out there that look familiar to us, given Brazil’s history.”